Sample Answers to Question 2
Corporate Tax
Spring 2016
PART A
Company’s E&P
Generally, a shareholder receiving property in
a non-liquidating distribution will have a dividend to the extent the
corporation has current and accumulated E&P. 301(c). If the corporation
does not have current or accumulated E&P, then the distribution will be a
return of the shareholders basis. 316(a). Finally, if the shareholder does not
have basis remaining, the transaction will be treated as a sale. For S to
determine whether or not the distribution of property is considered a dividend,
return of basis, or sale, Company must determine its current and accumulated
E&P. To compute E&P, Company will ned to start with its taxable income,
add back certain exclusions (e.g. tax exempt bond interest), add back certain
deductions (e.g. dividends received from another corporation), and then deduct
certain items normally not deductible (e.g. corporate tax paid, previous
dividends paid by corp). Also, Company will need to slow down its depreciation,
and it cannot use LIFO inventory reporting. Finally, there are special rules
for distributions of property and its effect on current E&P. On a distribution
of appreciated property, the distributing corp first increases its current
E&P by the gain recognized under 311(b) and then accumulated E&P is
reduced by the full FMV of the distribution. The accumulated and current
E&P is not determined until the end of the taxable year but the accumulated
E&P will be determined after the corp’s E&P increases due to the
property. C’s taxable income is 20k, but its E&P will increase 300K because
of the gain it will recognize on the property distributed to S. However, Corp
gets to decrease E&P by the amount of corp tax it pays. Current E&P is
not reduced by accumulated E&P but Company’s 2017 accumulated E&P will
take into consideration any negative 2016 E&P. There are not enough facts
to determine the exact current E&P for corp but it will be around 215K (20K
+ 300K - 105K (Corp tax rate .35 x 300K (gain on Black)) = 215K). Because C has
a deficit E&P going into 2016, E&P will not be subject to the
accumulated earnings tax.
Suri
For
the purpose of calculating the amount of the distribution, only the equity of
the property counts. 301(b). The shareholder’s basis in the property is its
FMV. In this case, S receives a distribution of 400K (500K FMV - 100K
Liabilities). Because the distribution exceeds current E&P of 250K, the
distribution is treated as coming from the current E&P using this formula:
(amount of each distribution) x (current E&P/total current distributions).
So 216K (400K x .53 (215K/400) = 215K). So S will have 215K of capital gain for
2016. The rest, 185K will be a return of her basis. Resulting in her basis in
her stock of 65K (250K - 185K = 65K). S’s
basis in Black is its FMV on the date of the distribution without any reduction
for liabilities. 301(d). S’s basis in Black will be 500K. Black’s holding
period will continue because the property is most likely a 1231 property.
Company
As noted earlier, C will recognize 300K (“lobster trap” effect) of most likely capital gain (because C has been using it in its business and assuming C has been using it longer than a year, Black is a 1231 property, therefore it is a 1231 property and all of the gain will be 1231 capital gain). 311(b). C’s E&P for 2016 is around 215K. However, the accumulated deficit “live on” and so the 215K E&P will be reduced by 50K. C’s 2017 accumulated E&P will therefore be 0 (215K - 50K - 165K (312(b)(1) cannot have E&P reduced below 0 because of a distribution)). C will have to pay corporate tax on the taxable income of 20K for 2016.
Exam No. 4010
This transaction is going to be treated as a
distribution under 301. In a 301 transaction, we first determine the amount of
the distribution. Then we look to current and accumulated E&P under 216 to
figure out what is a dividend. If there is amount of the distribution still
left after looking first to current and then to past E&P
The amount of the distribution for the shareholder is
determiend by the FMV of the property minus an liaibilities taken on by the SH
under 301. So, Suri has a distribution of 400k. Her basis in the property is
going to be 500k (or the FMV of the propety at the time of the distribution).
In determining the treatment of the distribution for
the shareholder, we first need to figure out what the current E&P is. We
know that they have a taxable income of 20k, but E&P is not equivalent to
the amount of taxable income. To figure this out, we need to start with the 20k
income, and then we add back exclusions and deductions (like bond interest
deductions, etc) and decduct cetain things (like previous dividends paid by the
corporation and federla income tax). E&P is meant to be a better
proximation of the corporation’s current economic status.
Here, we know that the total deductions are 180k. We
don’t know that we necessairly add in all of it, but certainly some of it will
be added in. While we are going to add in the distribution made this year at
the end for the purposes of calculating E&P, in calculating whether or not
the distribution is dividend, we are not going to do so. In other words, the
current E&P for the purposes of the 301 cacluation for Suri is going to
start with the current E&P as of the end of the year without distributions
made during that year. Here, that is somewhere between 20k and 200k (likely
somewhere less than 200k because of fed income taxes and other deductions that
are still permitted to stay in).
Her distribution had a value of 400k. No matter what,
the current E&P is not going to cover this whether it is 20k or 200k (note:
since there is only one distribuiton, we do not need to worry about alloating
this to each distribution proportinally). The accumulated negative E&P won’t
impact this determination at all. Suri then gets to treat whatever is left as a
sale or exchange under 301 and use up her basis. Since her basis is in the
stock is 250k, what is treated as current E&P is important. If the current
E&P is 150k, then 150k is a dividend taxable at dividend rates (currently
the same as capital gain). Then, 250k is treated as a return of basis and she
will not pay any tax on that portion of the transaction. If the E&P was
less than 150k, then whatever gain is over her 250k is going to be treated as
capital gain/sale if she is not a dealer in stock. If she does not use up all
her stock, whatever is left is going to be left as a basis in her stock. So, if
the full 200 gross income is considered E&P for the current year, she will
have 50k left in her shares of stock as basis to use up in the future (note:
unlikley because some deductions are permitted for calcuating E&P).
The distribution of the appreciated propety is also
going to impact their E&P. Normally on appreciated property the
distributing corp increases its current E&P by the gain recognized under
311 (reduced by any tax paide on that gain). In this case, the corporation is
going to increase its current E&P by 300k (the gain recognized). Then, the
accumulated E&P is going to be reduced by the full FMV of the distributed
proerty reduced by an liabilities (here, that is 400k). However, a distribution
can’t result in negative E&P. Since the historical accumulated E&P is
negative, this won’t have an impiact on the accumluated E&P - instead it
will just increase the E&P for the current year (2016) by the 300k gain
recognized.
The dividend paid by the corporation will then reduce E&P (the dividend paid here, as discussed above, greatly depends on what the amount of the E&P is at the time). Current E&P at the end of 2016 will be the 300k gain recognized minus whatever dividend they paid out to Suri.
Exam No. 4810
Distributions paid out of accumulated or current E&P
are taxable as dividends (§316). If the distribution exceeds both accumulated
and current E&P, then the distribution reduces basis in the stock and any
distribution beyond that is a capital gain (§301(c)(2)).
The current E&P for Company is $20K (gross income -
deductions). When the Company distributes property to a shareholder, the
Company recognizes any gain on that property before the distribution is made.
Thus the Company is increasing its E&P as if it sold the property. The gain
on the property is the difference between the FMV of the property and the basis
in the property ($500K - $200) which is $300K. The Company’s E&P will be
increased by post-tax amount of this gain. The gain will be taxed at capital gain
rates (unless the Company is a dealer in real estate and then it would be taxed
as ordinary income). Once the Company distributes the property to S, it will
reduce its E&P by the amount that is considered a dividend which will bring
the current E&P balance to 0.
S takes the property with its FMV reduced by the
assumption of liability. Thus she gets a distribution of $400K ($500 FMV -
$100K loan). The amount of the distribution that equals the current E&P
($20K + the post-tax gain on the property) will be a dividend to S. Up to her
basis in the stock ($250K), the remainder of the value of the distribution will
be a tax-free return of basis. If the distribution exceeds the sum of the
current E&P and the $250K basis in the stock, then any overage would be
taxed as LTCG (assuming she has held the stock over a year).
Her basis in the property is its FMV of $500K.
PART B
Exam No. 4073
The big
difference here would be that S-Corps don’t have E&P and any and all gains
or losses would pass directly through to the shareholder S. So, the gain that
is reported from the distribution of Blackacre will taxed to S directly,
additionally, the distribution will be a tax free return of basis to S. Since S’s
basis just increased by the gain (300k + 100k) S will have plenty of basis to
count against the distribution. If S’s basis in her stock dropped to -0-, any
further distributions would be capital gains to S. The 20k of ordinary gain
from the profits for the year will also pass directly through to S. The
character of the gain will be considered at the corporate level and that
character passes through to the shareholder, regardless of what the character
of the income would be in the shareholder’s hands.
Accordingly,
S’s basis in blackacre after the distribution will be carryover from the
corporation plus the amount of liability assumed, so here 200k + 100k = 300k. S’s
basis in the stock would be 250k (original basis) + 300k (gain on blackacre) +
100k (assumption of liability) + 20k (income for the year) = 170k
Keep in mind
however that because C switched from a C-Corp to an S-Corp in this year, all
the accumulated E&P will carryover. But since the E&P is negative it
will have no impact on the distribution to S.
Also, there
will be a double tax implemented on the built in gain on Blackacre from when C
switched from a C-Corp to an S-Corp. The corporation distributed the porperty
and recognized the gain within the “recognition period” of 5 years after
switching from a C-Corp to an S-Corp. Here all the gain would be built in and
would be taxed at the highest rate of 35%.
Exam No. 4810
Changing from
a C corporation to a S corporation is not a taxable event. However, any
property owned by the C corporation is still in the lobster trap. When the
property is distributed or sold, it is taxed to the S corporation as if it were
held by a C corporation but even worse because under §1374 the S corporation
will have to pay the highest corporate tax rate on any gain in the property
value that occured while the property was held by the C corporation. Any gain
that occurred after the switch to the S corporation is not taxed to the
corporation but is passed through to the shareholders. In this case, the
highest corporate tax rate is 35%. This is probably higher than the rate
Company would have paid if it had stayed a C corporation and had been able to
offset the gain with other losses.
Suri could
take the $20K current year E&P (excluding the property distribution) as a
tax-free distribution which would reduce her basis. This $20K would not be
subject to taxation at the corporation level and thus Suri would get more of
the $20K than she would have if the Company remained a C corporation and
distributed the $20K E&P. If the Company does not distribute the $20K, the
Suri will be taxed on it as pass-through income. Her basis her stock would
increase by $20K.
After the
Company pays taxes on $400K gain in the property distribution, the post-tax
money wil be distributed to Suri and she can apply the remainder of her basis
against the distribution to make it a tax-free distribution. If the
distribution is larger than her basis, then the overage will be taxed as
capital gain.
Suri’s basis
in the property is still $500K.
Exam No. 4986
Suri
In the Blackacre distribution, C’s E&P would not
dissapear with the change, but S would only be taxed on distributions that
exceed the amount of all current pass through income; essentially, if C had $15
of income and then distributed $20 to S, S would only recieve a taxable
dividend distribution to the last $5. Here, C’s recognized gain of $300,000 on
the transaction would pass through to S. This would also increase S’s basis in
her stock by the same amount, causing S’s basis to beecome $550,000 instead of
$250,000. As such, for S, the distribution of Blackacre would first be seen as a
tax-free reduction in her basis on the first $300,000 of it. At that point, S
would be recieving a distribution in excess of C’s pass through income, and as
such would recieve a dividend to the extent of C’s current year E&P (around
$20,000). The remainder of the distribution would then go back to being a
reduction in S’s basis under § 301(c) (here around $80,000). At the end of it,
S would have a basis in her shares of around $150,000.
Company
For C, however, they cannot aoid double tax on appreciated property. Because they are recognizing a built-in gain on Blackacre, C will still be taxed at the corporate level on that gain. § 1374. The only way this could be avoided is if C’s gain in Blackace occured only after they made the S election, which, considering it occured at the start of the same year as the distribution with only one month between them, makes it highly unlikely. C could avoid this double tax, but only if they had waited five years after they made the S election to do so. § 1347(d). As such, the same calculations as to C’s taxable gain above apply here when they made an S election. In addition, nothing would change vis-a-vis C’s E&P calculations.
Created by: bojack@lclark.edu
Update: 20 May 16
Expires: 31 Aug 17